Canadian Credit Health Update

2012 Q4

Introduction

These Canadian Credit Health Updates
are released every quarter. In these reports, I apply the same
analysis techniques that I used when watching the American financial
system through 2005-2009. If American and European-style problems
develop in Canada, I expect that these metrics will show early
warning signs just as they did in the USA. All data comes from public
financial reports.

This report contains: big five Canadian
banks' balance sheet health, off-balance sheet derivative exposures,
and national bankruptcy rates with a chart.

Summary for 2012 Q4

Big Five bank balance sheet
health is stable. Overall (average of banks), there is no change in
loan impairment from last quarter.

BMO
appears to have the worst impaired loans. Also note that TD is
under-reporting impaired loans, see details in 2011 Q4 report.

The Big Five banks have total
notional derivative exposure of $19.1 trillion, up 2.8% from a year
ago. The derivatives are 91% OTC.

Canadian bankruptcy rates
continue to decline in 2012. There is no sign of a bankruptcies
problem.

B.
Gross impaired loans / Total assets (higher = worse balance sheet):
A quick measure of deterioration on the asset side of the balance
sheet. In the USA, banks started having major problems at 1.5%, and
critical problems including insolvency above 2.0%.

Bank

2012.Q4

2012.Q3

2012.Q1

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

0.27%

0.26%

0.29%

0.32%

0.32%

0.55%

0.65%

0.69%

0.71%

TD

0.31%

0.30%

0.33%

0.32%

0.60%

0.62%

0.66%

0.56%

0.55%

CIBC

0.47%

0.49%

0.51%

0.52%

0.49%

0.45%

0.50%

0.52%

0.58%

Scotiabank

0.54%

0.54%

0.55%

0.71%

0.74%

0.74%

0.80%

0.84%

1.03%

BMO

0.57%

0.53%

0.49%

0.56%

0.48%

0.68%

0.74%

0.78%

0.79%

Average

0.43%

0.42%

0.43%*

0.49%

0.53%

0.61%

0.67%

0.68%

0.73%

* Note: banks switched accounting
standards in 2012.Q1

C.
Gross impaired loans / Tier 1 capital (higher = worse balance sheet):
This measure is very similar to the Texas Ratio, and compares the bad
loans to Tier 1 (Basel II) capital, the core measure of bank capital
which is primarily equity. If bad loans are a large % of the bank's
capital, it means the bank can not easily absorb the losses.

Bank

2012.Q4

2012.Q3

2012.Q1

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

6.1%

5.9%

6.7%

6.7%

6.9%

11.6%

13.9%

14.7%

15.0%

TD

8.1%

7.9%

8.9%

7.7%

15.0%

15.2%

16.1%

14.2%

14.1%

Scotiabank

10.4%

11.3%

12.1%

14.3%

15.3%

16.0%

17.1%

17.5%

21.6%

BMO

11.5%

11.3%

10.9%

10.7%

9.4%

12.7%

14.3%

14.9%

14.7%

CIBC

11.7%

12.0%

12.4%

11.4%

11.1%

11.1%

12.0%

12.4%

13.5%

Average

9.6%

9.7%

10.2%

10.2%

11.5%

13.3%

14.7%

14.7%

15.8%

D.
Tier 1 Leverage ratio (lower = more leverage, higher = better
capitalization):
This doesn't measure loan quality, but rather the bank's leverage and
aggressiveness. Tier 1 leverage = tier 1 capital / total assets. This
measure is included because more leverage (lower % here) translates
to greater overall risk. The banks with the worse loan books (above
tables) should exhibit less leverage (higher % here), otherwise it
means they are being too aggressive for their condition.

Bank

2012.Q4

2012.Q3

2012.Q1

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

TD

3.8%

3.7%

3.7%

4.2%

4.0%

4.1%

4.1%

3.9%

3.9%

CIBC

4.1%

4.1%

4.1%

4.6%

4.4%

4.1%

4.2%

4.2%

4.3%

Royal Bank

4.5%

4.4%

4.3%

4.8%

4.7%

4.7%

4.7%

4.7%

4.8%

BMO

4.9%

4.7%

4.5%

5.3%

5.1%

5.3%

5.2%

5.3%

5.3%

Scotiabank

5.2%

4.8%

4.5%

5.0%

4.9%

4.7%

4.7%

4.8%

4.8%

Average

4.5%

4.3%

4.2%*

4.7%

4.6%

4.6%

4.6%

4.6%

4.6%

* Note: banks switched accounting
standards in 2012.Q1

Off Balance Sheet Derivative
Exposures

Amounts
are in trillions of dollars. All amounts are notional, which is the
face value of a contract (the amount of underlying money represented
by a contract). These are not prices or market values of contracts.
In other words, $1 trillion of notional exposure does not mean the
bank could lose $1 trillion; however, it shows the magnitude of
derivative contracts.

OTC
exposures are included here because I believe OTC contracts are
particularly dangerous since they are illiquid, difficult to value,
and become worthless if the counterparty (another bank) collapses.

This
derivative exposure is hidden off-balance sheet where it can't
distress investors and depositors. The standard excuse given by banks
is that they are long some derivatives, and short others – and
the two (thanks to financial engineering) perfectly balance out risk,
resulting in minimal net exposure. But in reality, banks can only
maintain such perfect hedging during exceptionally low volatility. A
spike in volatility, or a counterparty failure, can suddenly create
enormous derivative book losses. This happened in 2007-2009 (wiping
out several banks), and will probably happen again. More derivative
exposure means more risk.

Bankruptcy Statistics

These
numbers from the government lag, but they are still valuable: this
shows total Canadian bankruptcies over time. Bankruptcy rates closely
relate to bank loan quality and losses. Note however that banks with
significant US/international operations have further credit exposure
beyond Canada, which isn't reflected in this graph.

Bankruptcy
rates have been declining in 2010, 2011, and 2012. There is no sign
of a bankruptcies problem.